Parents: 7 Questions Before Loaning Your Children Money

 

If you looked up a list of the top 10 mortgage lenders in Australia, one of the largest lenders might not be on the list.

It’s a lender we’ve all heard of: The Bank of Mum & Dad (BoMaD)

2 factors in the growing use of BoMaD

BoMaD is becoming increasingly popular as a source of finance for younger generations due to a combination of:

1. Significant property price increases in recent years
2. Increased willingness of parents to help their children get into the property market, due to the larger loans deposits now required.

Mortgage Choice reported that almost 60% of respondents to a survey were willing to provide financial help to their children for a home purchase.

In terms of the dollar value of loans made, BoMaD is the ninth largest mortgage lender in Australia.

BoMaD loans for other than real estate?

Typically, the BoMaD loans are for the purchase of real estate, but increasingly BoMaD is helping with the purchase of cars, boats and even holidays.

3 common traps with BoMaD loans

Where money is concerned, even the kindest gestures with the best of intentions can turn ugly if unforeseen changes happen in people’s lives.

Parents should go in ‘eyes wide open’ before joining the BoMaD ranks and providing loans or being guarantor for—that is, providing a commitment to repay or to provide security for—loans for their children.

BoMaD problems usually stem from three possible scenarios:

1. Divorce or separation: In the event of a divorce or separation in a child’s relationship, the BoMaD parents usually want the value of any assistance they’ve provided to be preserved for the benefit of their own child, not for the estranged or ex-partner. It can be stressful for parents to see a significant portion of their BoMaD loan going to someone who is no longer part of the family’s future. This only adds to an already stressful situation.
2. Financial hardship: Life can be complex and bad things can happen. A child might be unable to honour their agreed BoMaD financial commitment due to a loss of a job or earning capacity, or they could have health issues that place them  in a precarious financial position.
3. Family equity: “But that’s not fair!” Ever heard a young child exclaim this when a sibling was being given something? Well, adult children can often behave like that too. Where there is more than one child, parents need to carefully consider whether assisting only one child will cause family tension. The parents should keep in mind too, that the BoMaD financial assistance may affect the equity of allocating assets in their wills. If this is the intention, it’s important that this is documented in the wills and estate planning documents.

So, while parents may be happy to help, many details need to be addressed before the assistance is “approved”.

7 details to clarify first

Here are seven things you need to decide on when considering BoMaD assistance:

1. Type: What type of assistance is being provided?
   
   If a cash sum is to be provided, is it a gift or a loan?
   
   Are you guaranteeing the bank loan—either partially or wholly—or are you guaranteeing repayments?
2. Repayment: If it is a loan, what are the repayment terms?
   
   Is interest payable?
   
   If so, how is that to be calculated? What interest rate? Does interest compound? If so, on what basis: for example, monthly or annually?
3. Default: What are the consequences of default, both for you and for your child (and their spouse or partner)?
4. Who: Who are you lending the funds to? To your child or to the couple?
5. Guarantor terms: If you are providing any guarantees, make sure you fully understand the details and impact of the lender’s guarantor document. What does the lender require from you now and in the future?
6. Death or parent(s): What will happen if either or both parents die? Will the loan’s outstanding balance be forgiven or be treated as an asset of the estate and distributed according to the will? How will guarantee arrangements be replaced?
7. Death of child: What if the child predeceases either or both parents? Will the financial assistance continue in its current form?

Documentation is essential

The agreement must be embodied in a formal document. While you do not expect the agreement will be tested in court, there is always that possibility. Having the details clearly stated before any assistance is provided will reduce the likelihood of misunderstandings in the future.

Don’t try to Do-It-Yourself on the agreement documentation. Have your lawyer document the agreement in a formal, legally binding loan agreement. This is what any bank would do, and it’s what BoMaD should do too.

5 reasons to appoint a lawyer

Formally engaging a lawyer will:

1. Emphasise to everyone that this is a serious arrangement.
2. Ensure all parties to the agreement are clear on the details of the agreement before the assistance is provided.
3. Provide a ‘source of truth’ in the future if any questions arise.
4. Ensure all the issues relevant to your circumstances are agreed on. Note that the list of details above is not a comprehensive list.
5. Help everyone if the arrangement ends up in court.

Do your research

Just as another lender would research your child’s loan application before agreeing to it, so should you. How the following issues affect your decision on whether to proceed is a personal choice, but decide only after considering each of them:

1. The borrowers’ cash flow

Do they have sufficient cash flow to service all their debts (existing and proposed), allowing for the additional costs of home ownership (rates, insurance, repairs etc.)?

Although the loan repayments may be less than the rent they are currently paying, these additional costs can derail cash flow projections.

What margin of safety are you prepared to accept? There needs to be an adequate surplus to cover the inevitable unexpected expenses. What do you regard as adequate?

How stable is their income? Is their employment situation likely to change unexpectedly?

Can you foresee any disruptions to their income? Are they planning on having any (more) children? What is good news for you as a grandparent, might not be so great as their lender!

2. Your cash flow

If the agreement includes repayments, how will your cash flow survive if those repayments reduce or stop?

And how will your cash flow survive if you must honour a guarantee?

3. Savings history

A demonstrated ability to save before embarking on the home ownership journey is key to a successful outcome. In general, borrowers with a poor savings history before borrowing will struggle to meet loan commitments.

Ensuring your child has a savings mindset will give you some assurance and is an important attitude for your child.

4. Personal relationships

Although we have emphasised the need for a commercial-style approach to being the BoMaD, the personal relationships involved introduce an added layer of complexity.

An arms-length lender can be ‘brutal’ with terms and conditions, but the BoMaD needs to be sensitive to the personalities and long-term relationships involved. You do not want this transaction to be the cause of relationship stress or even breakdown.

And as noted above, relationships involving other children are potentially at risk here as well.

Clearly, we are not relationship coaches. We are merely noting it as a consideration. How you deal with it will be best managed by you.

Talk to us

Agreeing to ‘open a branch of the BoMaD’ is a significant decision. Be sure to make an informed decision and seek advice from your professional advisors. Get in touch with us if you’d like to make a time to discuss this with us.

Most BoMaD arrangements will end happily but this is another example in life where it’s best to, “Hope for the best, and prepare for the worst.”